Hybrid Mismatch Rules (Part 1) – Dividends and Franking

27 November 2017

On Friday 24 November, Treasury released draft text for the promised anti-hybrid rules. The Exposure Draft (ED) sets out two distinct measures:

* a universal rule denying an exemption for non-portfolio distributions received by an Australian company where those distributions are deductible by the payer, and a second rule denying imputation benefits for shareholders where a distribution paid by an Australian company has been deducted by the payer in a foreign country. This Riposte looks at these rules; and

* a suite of dedicated anti-hybrid rules modelled on the OECD/G20 recommendations published in October 2015. These rules will be examined in a separate Riposte.

While both measures affect "hybrids" and are constructed using many of the same definitions, nevertheless, they are functionally independent: the exemption and franking rules are very general in their scope and will apply in many cases where the dedicated anti-hybrid rules are not enlivened.

1. Distributions from foreign companies

The provisions will amend the existing non-portfolio dividend exemption to deny the exemption to a resident company if the entity that paid the distribution was entitled to a foreign income tax deduction in respect of all or part of the distribution.

Presumably these dividends are now meant to be treated as assessable income but with a FITO for foreign (interest) withholding tax if any, although that treatment might differ if the dividends are effectively connected to a foreign branch of the resident company.

It is important to note that this is a general rule; it is not constrained by many of the pre-conditions and limitations which surround the dedicated anti-hybrid rules. So it seems, at first glance, that a non-portfolio distribution from a foreign subsidiary would appear to be taxable in Australia if the subsidiary is resident in a country which eliminates the double tax on corporate profits as they pass through companies by a dividend-paid deduction system. These distributions are meant to be excluded from the effects of the dedicated anti-hybrid rules but they have not been carved out from the general rule.

Furthermore, there is no carve-out from the rule for circumstances such as conduit structures where our tax policy has typically allowed foreign dividend income to flow through Australia to foreign owners without triggering either corporate tax or withholding tax.

This rule would apply to distributions paid 6 months or more after the Bill receives Royal Assent.

2. Franked dividends

The provisions will also amend the franking rules to switch off the benefits of the imputation system where a resident shareholder receives (directly or indirectly) a franked distribution but the entity that made the distribution was entitled to a foreign income tax deduction in respect of the distribution. The distribution remains franked (so that the company's franking account is depleted) but no gross up is added to the shareholder's assessable income and the shareholder enjoys no imputation credit.

This rule requires both that the dividend is franked and that the Australian company paying the dividend is claiming a tax deduction, something which the debt-equity rules make impossible in entirely domestic structures. It can, however, happen where the distribution is being paid by a resident company but deducted against the profits of its foreign branch. The obvious allusion is to the instrument in the Mills decision.

This rule would apply to distributions paid 6 months or more after the Bill receives Royal Assent.

3. AT1 capital instruments

This part of the ED is intended to give effect to the May 2017 Budget announcement for certain Additional Tier 1 (AT1) capital instruments issued by banks and insurance companies – the so-called frankable/deductible instruments. The provisions provide that:

* returns on these instruments will not carry franking credits where the returns are tax deductible in a foreign jurisdiction; and

* the franking account of the issuer will be debited as if the returns were franked if the capital raised under the instrument is not wholly used in the offshore operations of the issuer.

The provisions in the ED just discussed will accomplish the first element; no separate rule is needed in relation to this as it will be covered by the general rule (see above).

The ED contains no specific rules about the second element. The Budget announcement provided that a new franking debit will be triggered even if the dividend is not franked, if it turns out that funds raised by the issue of an AT1 instrument are not being used wholly-offshore. The logic behind this provision was evidently to provide a level playing field for larger financial institutions with offshore branches viz-a-viz purely domestic institutions – i.e. not allowing deductible AT1 capital to be issued through a foreign branch with the proceeds of the issuance then being used in Australia.

The ED does contain the promised grandfathering rule for AT1 instruments issued prior to 9 May 2017. Such instruments will be grandfathered from the new hybrid mismatch rules – although the grandfathering will be restricted to distributions paid before the next “call date” of the instrument. Although not defined, the “call date” should be the first date on which the issuer is able to “call” for the instrument to be unwound or redeemed (typically such a call date exists a set number of years after the issuance date).